How to repeat the mortgage mess

A view shows the Fannie Mae logo at its headquarters in Washington March 30, 2012.

In September 2008, amid the financial panic and collapse of the housing market, the federal government bailed out and took control of Fannie Mae and Freddie Mac, two government-sponsored enterprises that dominated the mortgage market. After four years and $180 billion of taxpayer funds to keep them afloat, they are beginning to make profits from their near monopoly. This week, the head of the federal agency that supervises Fannie and Freddie, Edward DeMarco, outlined a sensible plan that would prepare the companies—which remain the dominant players in housing finance—for either full privatization or government ownership.

These are the obvious alternatives, but there is a third idea in the mix, one that is as seductive as it is dangerous: a private system but with an explicit government mechanism for future bailouts when they prove necessary. The rationale? If there’s a problem in housing finance, the government will inevitably step in as it did in 2008. So why not create a government insurance program now, compensating taxpayers for the burdens they will have to shoulder eventually anyway?

This argument has been advanced many times since Fannie and Freddie went under, most recently by the Bipartisan Policy Center, a Washington think tank. The center’s plan, released to the public late last month, is already getting some favorable media attention. It is likely to get increasing attention in Washington, since it is headlined by two former Housing and Urban Development secretaries (Mel Martinez and Henry Cisneros) and two former senators (Democrat George Mitchell and Republican Kit Bond).

A system for private housing finance with a government insurance backstop may sound reasonable, even sophisticated. But it is seriously flawed.

First, such a system cannot logically be contained. There is nothing special about housing. Lest we forget, the government also stepped in to rescue the domestic auto makers five years ago. Why not a backstop now for Detroit? At the end of this road is bailout nation: a government insurance backstop for every industry.

Second, taxpayers never get compensated by establishing insurance funds. Congress, when it passed the Hurricane Sandy aid bill, bailed out the National Flood Insurance Program to the tune of $9.7 billion. That program had collected insurance over many years to protect against events like Hurricane Sandy—but it wasn’t enough.

Other federal insurance systems that have gone or are going broke include the Federal Housing Administration, the Pension Benefit Guaranty Corporation and the Federal Savings and Loan Insurance Corporation. To stave off insolvency, the Federal Deposit Insurance Corporation in 2009 ordered banks to pay three years of insurance premiums in advance.

Congress lacks the incentives of private insurers to charge risk-based rates or to create and maintain the large funds necessary to deal with catastrophic losses. There is always an incentive to keep rates down to placate interest groups, or to say the fund is large enough—until disaster strikes and the country learns it isn’t.

Third, federal insurance encourages careless behavior by those who know that if things go bad, someone will be there with a bailout.

Consider the Bipartisan Policy Commission’s plan, “Housing America’s Future.” The government’s role would be to backstop a private system of mortgage insurance. The backstop will only come into play if private insurers can’t meet their obligations.

The downside? Investors in mortgages or mortgage-backed securities created under the plan would have little incentive to care about the quality of the loans—precisely because they would ultimately be protected from losses by the government. Nor would the creditors of the private mortgage-insurance companies care about the quality of the mortgages or the companies’ capital positions. The government would bail them out too if the insurers failed.

This would make it all the more likely that mortgage insurers wouldn’t be able to cover low-quality mortgages that the government backing induced investors to buy.

Fourth, Congress will do what it always does—expand the program so that it covers more and more mortgages of lower and lower quality. This is what happened after affordable housing goals were imposed on Fannie and Freddie in 1992, and when the Clinton administration made the Community Reinvestment Act into a quota system in 1995. Congress has also authorized increases in the size of mortgages that Fannie, Freddie and the Federal Housing Administration could acquire, most recently by raising the maximum for FHA mortgages to $729,000 (from $625,000) in 2012.

These changes were strongly backed by a variety of interest groups, including community activists, real-estate agents and home builders. The pressures from these groups, beginning in 1992, succeeded in degrading mortgage underwriting standards, causing the mortgage meltdown that triggered the 2008 financial crisis.

If an insurance backstop program such as the one proposed by the Bipartisan Policy Center is put in place, the same dismal process will be repeated. Congress loves programs that deliver financial benefits today with the inevitable catastrophes put off into the future. These programs are even better when lawmakers themselves can tell their constituents—and may even believe—that this is merely a federal backstop to a private system.

Once a fund of any size is created to back a particular industry, the arguments against a bailout virtually disappear. After all, what is the program for? Aren’t the funds already there to cover the losses? In reality, sufficient funds are not going to be there. In a perpetual-deficit world, the money also has to be borrowed, adding to the national debt.

Since Fannie and Freddie were bailed out, there has been no end of plans to maintain the government’s role as guarantor of mortgages for housing and other real estate. They will all end up putting the country back on the road to another crisis. The only way to ensure a stable mortgage market is to get the government out, and keep it out.